The type of business entity a general dentist uses to operate his or her dental practice can have significant financial, legal, tax, and operational effects during a professional career. Whether to start a practice from scratch, to purchase a practice, or to operate with other dentists, the model of business entity or form chosen is a decision that requires thought and planning prior to the initial opening or purchase of the practice and throughout the course of time the business remains in operation. The expertise of an accountant and an attorney who have experience in working with dentists can be invaluable when they are consulted prior to establishing or purchasing a dental practice.
In this chapter, we discuss the operational, tax, and management aspects of the four most common entities that are used to operate a dental practice: sole proprietorships, corporations (both S corporation and C corporation), partnerships, and the limited liability company (LLC).
The sole proprietorship is the least complicated of the available business entity forms. As a sole proprietor a business is simply operated under an individual’s name (for example, John Smith, D.D.S.). A sole proprietorship may also use a specified title, or a “doing business as” name (or d.b.a.)
Unlike the other entities to be discussed later in this chapter, with the sole proprietorship, other than one’s professional license, there generally are only a few business application forms necessary to local, state, or federal government agencies to establish this business entity. Typically, the practitioner only needs to obtain a business license from the local jurisdiction (city, county, etc.), a state dental license, and federal and state drug prescription licenses. The owner sole proprietor will need to secure a federal tax ID number for employment tax purposes. Some states may also require a special tax license. Although a dentist may use his or her individual name and title (for example, John Q. Smith, D.D.S.), the business may also operate under a d.b.a. name. In the case of a d.b.a., John Q. Smith, D.D.S. could use as his d.b.a., Lincoln Avenue Dental. He may choose to do so for unique marketing and/or identification purposes because the practice is located on Lincoln Avenue. But in order to do this, Dr. Smith is typically required to post notice in the local newspaper for a period of time (usually a month or 2), or file the assumed name with the local county government prior to the opening of his business. This serves as legal notice to others who may have a similar name, to be made aware that Dr. Smith intends to use Lincoln Avenue Dental as his d.b.a., and if others have a conflict with Dr. Smith’s d.b.a., they have adequate time to legally contest the use of Dr. Smith’s d.b.a. business name.
Operational and Management Aspects
To begin operating as a sole proprietorship, one needs to go to a bank (typically a local bank) and open a business bank account. Usually a checking account is the first account established. This account is opened under the name of John Smith, D.D.S., or his d.b.a. The account, even though used for business purposes, is treated as a personal account of Dr. Smith, and Dr. Smith is personally and legally responsible for all activity on the account, just as he would be for his personal checking account.
As the owner, all deposits or income of the dental practice are placed into this account and are used to pay office expenses. Additionally, the practitioner may also decide to open a business savings account for the practice. But again, the savings account, while used for business purposes, is still considered a personally guaranteed account of the practitioner. Personal income from the business to the dentist is usually taken from the business account in the form of a draw or check. This can be any amount and may be taken at any time, depending on available funds. While some dentists may choose to pay personal bills such as mortgage payments, home utility bills, and so forth from their business account, it is not recommended. If personal bills are paid from the business account, they must be treated as personal draw checks or personal income. This may create confusion regarding business expenses versus personal expenses in calculating true business overhead and in paying the correct taxes at year’s end. Instead, most dentists take a periodic monthly draw, transfer it to their personal bank account, and use their personal account to pay personal bills. This allows clear delineation of business versus personal expenses. Draws taken from the business account will obviously depend on the cash flow, or income and expenses, of the business. As collections and overhead expenses in a dental practice can be variable from month to month, draw checks also vary as to amount and as to when they are taken for personal use.
Again, we do not recommend that you pay your personal bills from the business account. By taking a periodic, and preferably a set monthly, draw from the business, a personal as well as business “budget” can easily be established. This in turn will allow for the accumulation of more money both personally and in the practice, which over time can provide a means for larger equipment purchases, retirement planning, and so forth. Paying all personal bills through a business account makes it harder to save money and meet goals in both the business and in personal life.
Income Tax Issues
As a sole proprietor, earnings from a dental practice are reported on the practitioner’s individual income tax return. Business gross income and allowable business expenses are reported on Schedule C of Federal Form 1040. The net income of the practice is shown at the bottom of Schedule C and then is transferred to page 1 of Form 1040. Thus, business income is reported just like any other type of income on a personal tax return.
Example: Dr. Smith’s dental practice collected $600,000 for the current tax year. His deductible business expenses (staff salaries, lab, supplies, depreciation, etc.) for the year were $400,000. Dr. Smith will report income on his individual income tax return of $200,000 for the year.
When starting dental practice, it is possible to incur a loss of income (and is most likely in the first few months or perhaps years of operation). This loss is tax deductible if the individual’s personal investment in the practice is what is called “at risk.” For example, if a practice that is started on October 1 collects a total of $40,000 for the months of October, November, and December, and during that same period the expenses of the practice are $55,000, there would be an operational loss of $15,000. If money to fund the $15,000 loss is borrowed from the bank and the dentist is personally liable for the loan (which is typically the case with bank loans), then the dentist is considered “at risk” for the $15,000 loan and is permitted to deduct the loss on his or her personal tax return.
For purposes of allowable tax deductions, now is a good time to discuss the concept of depreciation. As a dentist, the sole proprietor typically operates on what is referred to as the cash basis of accounting. This requires the practitioner to report receipts (income) as collected and deduct all expenses as paid. The one exception is for fixed assets (like equipment, furnishings, or fixtures) purchased for the business. For tax deduction purposes, fixed assets are allowed to be depreciated, or expensed to offset taxes, over time. This means that instead of taking a full tax deduction the same year equipment is purchased, the individual is allowed to depreciate or deduct a portion of the cost of that equipment over a period of several years.
Example: Assume Dr. Smith buys $100,000 of dental equipment. Federal tax law says that he can depreciate dental equipment over a period of 5 years, however, it takes 6 calender years to fully depreciate a 5 year asset. So the doctor’s allowable tax deduction each year for this purchase equipment is, according to current tax law, as follows:
|Year 1 (20%)||$20,000|
|Year 2 (32%)||$32,000|
|Year 3 (19.2%)||$19,200|
|Year 4 (11.52%)||$11,520|
|Year 5 (11.52%)||$11,520|
|Year 6 (5.76%)||$5,760|
Note: There is an exception or provision that was put into law several years ago regarding the depreciation of newly purchased fixed assets. This tax law provision is referred to as Internal Revenue Code Section 179 and allows for the full deduction of expenses for equipment purchased in the same year it is placed into service up to specified total or maximum, which currently is $125,000. This tax provision has been created as an incentive for small business owners to expand their businesses. This in turn is intended to help stimulate the U.S. economy. So with the Section 179 provision, a small business like Dr. Smith’s is allowed to expense or deduct the cost of all the equipment in 1 year instead of depreciating it over a 5-year period as shown in the example above. There are no restrictions for the sole proprietor, other than the total amount per year, in taking this deduction, and this deduction can create a loss on the practitioner’s Schedule C for the year, as long as the individual is “at risk” (as previously discussed) in the investment or cost of that equipment. Remember, no matter how the equipment is paid for, whether through a bank loan, dental specialty lender, or from private resources, such as a family loan, and regardless of when the loan is paid off, the cost of equipment is deductible in the year it is placed in service.
Example: Dr. Smith opens a new dental office the first day of October. He has worked the first 9 months of the year, earning $100,000 as an associate in another office, where he intends to continue to work a few days a week as an associate until his new practice is busy enough for him to quit the associate position. He will earn an additional $20,000 for the last 3 months of the year as an associate; thus, he will have total income from the associate position of $120,000.
For the first 3 months of his new practice (October, November, December), Dr. Smith’s office collections are $40,000, while the operational expenses (before depreciation) are $55,000, leaving a loss of $15,000. Assuming Dr. Smith purchased $100,000 of equipment and furnishings to start the new office, and that these were placed in service on October 1, the day he opened the office, he can elect to use Section 179 to deduct all or any part of the $100,000 equipment and furnishings purchased and can increase his deductible loss on Schedule C to as much as $115,000 ($15,000 operating loss plus $100,000 Section 179 equipment expense). This $115,000 loss would almost totally offset the $120,000 in salary from his associate position and would result in Dr. Smith paying little or no taxes for the year.
As you can see, there is significant tax planning that should be done, especially in the first year of a new dental practice. Again, consultation with an accountant with experience in this area is critical.
With regard to payroll taxes, all persons who work as employees and receive W-2 wages not only pay income taxes but are required to pay into both the Social Security and Medicare systems. An employee, like a dental assistant, pays 6.2% of wages up to an annual limit in Social Security tax, and the employer matches this amount. The employee will also pay 1.45% of wages in Medicare tax (there is no income limit on Medicare withholding), which is again matched by the employer.
As a sole proprietor the owner is not only liable for employer taxes on employee wages (Social Security and Medicare as mentioned above) but also for what is known as the self-employment tax for the practitioner’s earnings. Because a sole proprietor is earning income (draws) and thus is not likely receiving a true payroll check, the government created the self-employment tax, which is computed on an individual’s tax Form 1040 (Schedule SE) each year. A sole proprietor is in essence both the employer and employee and must pay both halves of the Social Security and Medicare tax each year based on calculations from the tax Form 1040 Schedule C profit. This is something that must be taken into account in planning taxes. Self-employment tax can and often does run into five figures annually, and without proper advanced tax planning, many sole proprietors find themselves financially challenged when it is time to pay their self-employment taxes.
Finally, the sole proprietor is not allowed some of the same tax deductions that a C corporation is allowed. These include things such as deduction of long-term disability insurance premiums, medical reimbursement plan contributions, child care plan contributions, cafeteria plan contributions, and so forth. This will be discussed further in the corporation portion of this chapter.
One of the disadvantages of operating a business as a sole proprietorship is that the practitioner’s personal assets are subject to creditor claims in the event of a lawsuit stemming from the operation of the business. Other types of business entities, yet to be discussed, can provide personal liability protection against such suits. In the event of a lawsuit against a sole proprietorship, creditors can seek compensation in the form of personal property, that is, real estate, vehicles, and even personal investment accounts. However, insurance can protect against general and professional liability judgments.
Example: Dr. Smith operates his business as a sole proprietorship. He owns a home and three pieces of rental real estate and has personal investment accounts. In his third year of business, he terminates the employment of the front office manager, Julie, who in turn sues Dr. Smith and wins a civil judgment in court for $75,000 for wrongful termination. Because he is operating the business as a sole proprietor, Dr. Smith is personally liable for this $75,000 judgment to the former employee. If he does not have the cash to pay this former employee, she can go after his home, real estate, and investment accounts to secure and settle her judgment against Dr. Smith’s business.
Again, consultation with an attorney who works with dentists in the matter of liability of a sole proprietorship is absolutely critical before choosing this business model.
The advantages of operating as a sole proprietor begin with the simplicity of this form of doing business. There are few government submission requirements, no need for the owner to take salary and withhold taxes (sole proprietors, however, usually plan for and pay their income taxes using quarterly estimated tax vouchers), and no annual state or federal filings that are commonly required of corporations, partnerships, or LLCs. It is simply the least complex business entity for operating a business.
There are two major disadvantages to operating as a sole proprietor. First, the liability issue as discussed above (this issue alone in many cases steers the decision of business entity away from the sole proprietorship). Second, experience shows that Schedule C sole proprietorships have a higher rate of being selected for IRS tax return audit than do corporations, partnerships, or LLCs.
For dentists entering practice ownership, forming a corporation has many advantages and a few disadvantages that will be discussed. As mentioned in discussing sole proprietorships, business owners are strongly motivated to form corporations by the liability protection it offers for their personal assets. Done correctly, forming a corporation will in most cases protect personal assets, such as homes, cars, and investments.
However, incorporating requires that the business owner follow certain formalities, which include taking income or salary just like other employees (paying regular income taxes through payroll deduction vs. self-employment tax) and having to file certain government forms throughout the year. While providing a method of insurance against personal liability, the corporation can also provide certain income tax benefits. Characteristic differences between C corporations and S corporations will be delineated and are generally differences in taxation.
Description and Necessary Documentation
A corporation is a legal entity typically formed by submitting a fee and a state-specific application. The business owner typically creates the corporation when he or she transfers money or other property (that property being dental equipment, furniture, fixtures, and other practice assets) to pay for, or in exchange for, stock in the corporation. In dentistry, most corporations are typically started for a transfer or cost (known as capitalization) of between $1,000 and $5,000.
It is strongly recommended that an attorney be employed to submit the necessary paperwork, such as articles of incorporation and bylaws, to the secretary of state or other agency responsible for forming corporations in the state in which the corporation is to be formed. Following the legal formalities to form a corporation is critical. If a corporation is not formed correctly, and thus is not in good standing with the state, another party could “pierce the corporate liability veil” if a lawsuit occurs. A lawsuit can be catastrophic to the stockholder if the corporation is found not to be a legal entity because the shareholder is personally liable for the lawsuit judgment (just like the sole proprietor).
Once the state approves and returns the articles of incorporation and bylaws, a corporate seal or stamp is created. This seal may be created by the state or may need to be done with the assistance of an attorney. Next, with the help of a local bank, a corporate bank account can be created. For legal purposes, banks will oftentimes require copies of the articles of incorporation, the bylaws, and the corporate seal in order to establish a corporate business account. In addition, the corporation will need to obtain a federal employer number or tax identification number, also known as a TIN. This number is needed to file corporate tax returns and to send claims to insurance companies for the dental services provided to patients of the practice.
Dentists desiring to operate their business entity in the form of a corporation, whether at the start of a new practice or when purchasing an existing practice, will normally transfer some cash to the corporate account to purchase the stock, and also to provide working capital to the corporation. The dentist/shareholder can then acquire a loan from a bank or a specialty dental lender in the name of the corporation. For example, say Dr. Susan Jones is operating her dental practice as a corporate entity (Susan Jones, D.D.S., P.C.) and decides to borrow the funds to buy another existing practice that costs $400,000. In purchasing the existing practice, the assets of that business are allocated among equipment, furnishings, supplies, goodwill, and probably a covenant not to compete. All of these assets will become assets of her corporation. The corporation is actually buying the practice and will be liable for the debt. So the corporation will have $400,000 in assets and $400,000 in bank debt. Dr. Jones is simply the stockholder of the corporation.
However, issues are much more complex for a dentist who has operated his or her practice as a sole proprietor for many years and then decides to incorporate. Before incorporating, it is very important to consult with an accountant to determine how much in assets and liabilities the sole proprietor has immediately preceding the proposed incorporation. This determination is critical due to the potentially onerous tax provisions of Internal Revenue Code Section 357.
When a sole proprietor incorporates, if the sole proprietor transfers liabilities (what is owed) in excess of the basis (original cost) of assets to the newly formed corporation, the excess, or difference, of liabilities over assets is considered taxable income to the dentist (that is, the sole proprietor “on paper” is gaining income from forming the corporation). Accounts receivable (what is owed to the business) and accounts payable (bills the business needs to pay) are excluded from this calculation.
Example: Dr. Jones has been operating her sole proprietorship for 4 years. She decides to incorporate as of January 1. The assets of her pract/>